Scenario	99/00	00/01	01-/02	02/03	03/04	04/05	05/06	06/07	07/08	08/09	Total
Current Commitments	0	8	63								71

The following is a list of pressures on the Defence Capital Plan. These pressures are a mix of those that are within the control of the Ministry of Defence and NZDF, and those that are not:

• The impact of inflation: Although the New Zealand Consumer Price Index (CPI) has measured inflation of 2% or less for some time, the underlying inflation rate for military equipment has been estimated by the NZDF at between 3% and 8%. As the figures in the Defence Capital Plan do not account for inflation, the result is a progressive reduction in capital purchasing power.

• Currency fluctuations: As most capital projects involve overseas vendors, and contract prices are expressed in foreign dollars, the Defence Capital Plan is subject to the effect of fluctuating exchange rates (partly due to differing inflation rates as discussed above). Although the Ministry of Defence hedges foreign exchange exposure once a vendor is selected and approval-to-commit is given, a large number of projects on the Defence Capital Plan have not reached this point of advancement.

• Changes in project scope: Often the scope of projects increases over time as more detailed work is conducted. Examples of this include increases in the estimated level of logistical support and spares required, such as occurred with the replacement maritime helicopters, along with increases in the quantity of equipment and features subsequently found to be necessary.

• Insufficient knowledge on which to base project costs: In some cases initial cost assessments are based on imperfect information, which invariably leads to inaccurate cost estimates being made. Based on past capital procurement acquisitions, the initial assessments of project costs are often overly optimistic.

• Cashflow issues: Another capital investment difficulty is that the steady, smooth cash flow of depreciation does not match the lumpy cash flow associated with purchasing major pieces of equipment.

• National Real Estate Review: The 1997 Defence Assessment factored in significant capital and operating savings resulting from NZDF consolidating their real estate portfolio. This included some rationalisation of bases and housing. However, the previous government did not proceed with the consolidation of the NZDF real estate and this has resulted in foregoing a saving of approximately $150 million.

Annex 2 Operating

Following the DA97 the Government provided increased operating funding for a two-year period (1998/99 and 1999/00). Beyond this, additional operating funding increases were signalled, but not formally included in NZDF baselines. It was understood that these increases would be sought as necessary to meet the Government's defence policy objectives and as the capital assets came on stream. At the time the baseline was set, the Chief of Defence Force also agreed to an effective three year freeze on baseline increases (from 1997/98 to 1999/00 inclusive). However, in reality NZDF has received increases in appropriation for deployments such as East Timor. These increases for 1998/99 and 1999/00 can also be seen in Table 7 below.

	1998/99	1999/00	2000/01	2001/02	2002/03
DA 1997 Projected baseline	1349	1380	1413	1427	1457
Current baseline	1368	1397	1386	1406	1416

The current baseline in Table 7 above also includes the operating appropriation changes (as approved in the final Cabinet paper) for the F-16s.

This operating budget built in significant internal savings to be made within the NZDF as a result of Defence Management Reviews (DMR), and a rationalisation of real estate holdings. Some of the DMR savings have not been achieved to date, and the real estate rationalisation was unable to be progressed. NZDF have continued the DMR process and have now included efficiency reviews in areas that were not indicated at the time of the DA97.

A significant feature of the operating cost components of the NZDF is the breakdown between fixed and variable costs. Some 90-95% of the total costs are fixed costs that cannot be easily changed in the short term.

The variable costs are those associated with consumables such as training, ammunition, fuel, rations, travel costs, repairs and maintenance.

Cutting back on these variable costs can only make short-term savings. The result is less training and exercising, or other supporting activities such as maintenance.

Significant long-term savings are only available if inroads are made into the 90%-95% fixed costs. To achieve this it is likely that a NZDF capability (or output) would have to be cut, or at least significantly reduced.

NZDF also face additional operating pressures some of which are controllable and some of which are not.

• Real World Operations: NZDF is only funded to D-LOC (Directed Level of Capability). D-LOC is the level of capability that the NZDF is able to maintain in order to provide Government with options for the commitment of military forces. D-LOC is expressed, in the Minister of Defence's purchase agreement, as the number of hours or days that the capability is away from being operationally capable.¹⁸ Additional funding is required (and sought by NZDF) to 'work' the force elements up to O-LOC (Operational Level of Capability) at which stage they are at a level to be deployed into an operational theatre. For example, the recent deployment to East Timor could not be funded from within NZDF baselines as it requires NZDF to sustain a deployment at O-LOC.

• Foreign Exchange: A major source of risk in the past has been currency fluctuations. Following a joint NZDF/Treasury initiative, a mechanism has been set up which can allow Ministers to adjust operating baselines during the budget process to reflect changes in NZDF purchasing power.

• Personnel Costs: The NZDF baseline from 2000/01 onwards, makes no provision for increases in pay and allowances for either uniformed or civilian personnel.

Institute
of
policy
studies

This is an updated version of previous drafts of a paper on this subject by the author. It includes additional material and replaces earlier drafts.

Institute
of
policy
studies

THE TASK

Part 1 examines the costings contained in a spreadsheet supplied to Treasury by NZDF (labelled "economic valuations F-16 74.xls"). It forms the basis for an estimated NPV (net present value) of the proposed F16 A/B purchase. The purpose of this part is to examine the methodology and the robustness of the NPV calculations to different assumptions.

Part 2 examines an alternative approach to calculating the benefits of the F16 purchase, using accrual accounting methodology applied to the output class D11 (Air Combat Forces). Using these figures as a base, we can compare the present discounted value of costs pertaining to the F16 A/B proposal with those pertaining to a combined A4-F16 C/D approach. This approach also enables us to examine the time profile of fiscal costs across the two options.

These two parts take existing defence policy as a given. In particular, they assume that New Zealand will continue with its policy of maintaining balanced forces capable of operating with the forces of partner countries. It is important also to consider the F16 purchase in a broader scope, by examining implications for defence force structure if the maintainance of balanced forces is altered¹⁹. This is done in Part 3, with the proviso that the analysis of the inter-force trade-offs should only be considered a preliminary attempt to assess the trade-offs; a complete analysis of defence options is required to quantify these trade-offs more fully.

18 For example a signal squadron is ready for deployment in 60 days, to provide secure communication and dispatch services support within a peace support mission area for up to 12 months. return